Warner Music is IPO of the week

RenaissanceCapital

Editor's Note: Renaissance Capital runs the IPO Plus Fund
IPOSX
The fund may have investments in the securities mentioned in its report. For more information, see the company's Web site at www.ipohome.com.

GREENWICH, Conn. (MarketWatch) -- After buying Warner Music Group from Time Warner in 2004 for $2.6 billion, Edgar Bronfman Jr., along with private equity shops Thomas Lee Partners, Bain Capital and Providence Equity Partners, is wasting little time in bringing the global music company public.

The IPO, scheduled to price Tuesday evening, will enable its financial backers to liquidate a portion of their holdings and generate $581 million in proceeds for the company, which it will use to repay debt.

For those who aren't familiar with the company, Warner Music Group
WMG
is one of the premier names in the business of recording and publishing music.

Under its Recorded Music segment (83% of revenue), the company records an artist's music, then licenses and sells it in physical format (mostly CDs and DVDs) or purely digital format through distributors to mass merchants, record stores and online retailers, which include digital distributors such as iTunes by Apple
AAPL

Its Music Publishing segment (17% of revenue) licenses and acquires rights to musical compositions from songwriters and composers and receives royalties and fees for their use.

Warner Music Group owns a large music catalog, including a roster of 38,000 artists and 27 of the top 100 U.S. best-selling albums of all time. Among the artists Warner Music has courted into its music empire are the Eagles, Madonna, Fleetwood Mac and Sean "P Diddy" Combs.

Sales from this catalog, along with new releases of established artists and fees from its publishing business, generate a rather predictable and recurring revenue stream for the company.

While the story sounds good so far, one thing has increasingly troubled the industry over the past few years, particularly with the advent of the Internet: piracy.

From 1990 to 1999, industrywide music sales were strong as a result of the conversion to CDs from LPs and cassettes. Butdigital piracy caused worldwide music sales to decline 5% to 8% annually from 1999 to 2003. Warner Music, along with its peers, now hopes to reverse this trend by introducing new technologies and continuing to prosecute file-sharers and pirates.

While trying to resurrect sales on that end, the company's experienced management, headed by Bronfman, sees strong opportunities to grow in the digital space and plans to transform the company into a digital music content provider while continuing to benefit from recurring revenue streams from its traditional records and songs business.

While we give its highly regarded executives credit for having completed a major restructuring and cutting significant costs, its new management has yet to successfully execute its strategy to transform Warner Music into a digital-content company. We also remain concerned about the piracy issue, which will remain a serious challenge to developing a profitable digital-music business.

In addition, like a host of recent deals where large buyout firms have swooped in to pick up major franchises and quickly prepped them for public offerings while handsomely paying out insiders, we were turned off by the significant dividend payments to Warner Music's financial sponsors and executives both prior to and on the IPO.

Finally, while there is no close comparable trading in the U.S. for valuation purposes, relative to other large media franchises such as Disney
DIS
and parent Time Warner
TWX
Warner Music Group comes to market at a premium multiple based on both trailing and projected operating cash flow.

Despite these concerns, a lot of buzz surrounds this deal, which we believe will help Warner Music Group's IPO off to a good start. But those placing their bets will be doing so based on management's expertise and prior successes.

No doubt: Warner Music Group has built a premier music recording and publishing franchise. But the jury is still out on whether it can make its transition to a digital-content company a Grammy-worthy performance.

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